Last week, Sadie wrote about how debt free living means not being a slave to a FICO score. In the article, she pointed out that FICO has become such an integral part of our lives that even the debt free can’t ignore the score completely, which is annoying, at best. But I’ve been giving it a lot of thought and I think that this recession might be the end of FICO as we know it. I’m not ready to declare the complete death of the score because I have a feeling it will be like roaches — impossible to kill completely. But I do think that the way the score is used and how it is calculated will have to change when this recession is over.
The credit card industry and banks, in their effort to cut their liabilities and reduce the amount of open credit on their books are slashing credit limits and closing accounts and lines of credit left and right. They’re even doing this to people that have no debt, don’t carry balances and have outstanding scores. This is fine for them; it prevents all of that open credit from suddenly being utilized and not paid back. But in the process, they’re killing their best friend, FICO. Here’s how.
When FICO calculates your credit score, a huge part of that score is your available credit to debt ratio. So if you have $30,000 in available credit, but you’re only carrying $1,000 in debt, you’re score will be much higher than the person who has $30,000 in available credit and is carrying $25,000 in debt. The closer you get to maxing out your credit, the lower your score will be, even if you are consistently making the required payments on that debt. This is why some financial advisors recommend not closing a credit account once you’ve paid it off. If you close the account, you reduce the amount of credit available to you, lowering your FICO score.
Now, imagine that you’re the person with $30,000 in available credit and $1,000 of debt. You’re doing great. Now one credit card company closes your card, chopping $10,000 off your available credit. Another drops your limit by $5,000. Now you’re down to $15,000 in available credit. Then, for giggles, your bank drops your HELOC by $5,000. You’re now sitting at $10,000 in available credit and $1,000 in debt. You’re still in an okay place debt-wise, but your FICO score has, by now, dropped quite a few points through no fault of your own.
If you don’t use a lot of debt, this won’t be a huge problem, right? Not necessarily. Your score is used to determine your insurance rates. Employers use your score to determine your employability. Apartment owners use the score to determine who can be a tenant. Utilities check it to see if you should have service. A low score means you will pay higher deposits and fees if you are granted housing or utility service. And, of course, a lower score will impact your ability to replace those closed cards or get a loan or mortgage if you need one.
If you had a very high score to begin with, the impacts on your life will likely be minimal. But what if you were sitting on the borderline between a great score and an average score? Or a good score and a poor score? And then you lost whatever foothold you had simply because the credit industry decides to slash your limits? You will end up paying more for everything and possibly being denied some things you need. All through no fault of your own.
In reality, your FICO score will no longer reflect your ability to handle credit. Because the lowering of your score comes about through the actions of others, it will become worthless to judge you as a credit risk. Yet I bet many places will still place great importance on that score, even if it has been turned into complete fiction. Think there won’t be a backlash from that? My guess is that as more and more consumers realize what is happening to them and that it’s happening through no fault of their own, the anger against FICO and the credit industry will build. When those people who have never had any credit troubles are denied housing, jobs, and insurance because their score was lowered by the arbitrary actions of the credit industry, they will be mad. Smart consumers will demand to be judged on something other than a computer generated score that is no longer a reflection of their ability to handle debt. If it happens to you, rise up and complain.
What’s funny to me is that FICO is the credit industry’s best friend and it’s the credit industry that will ultimately kill it with their actions. FICO makes it oh so easy for lenders to determine who gets what. Just pull up a score and roll the dice. It takes away independent thought and decision making. But this slash and burn method of lowering credit limits is, in my opinion, going to be the undoing of FICO. FICO is already a less than perfect way of determining your credit worthiness. The actions of the credit industry will end up stripping FICO of whatever credibility it has left.
So once FICO’s been stuffed in a dark corner, what’s left? Lenders and others with whom you want to do business will have to go old school. They’ll have to actually get to know the people they’re making loans to and bringing into the workplace. They’ll have to look at the total picture of the person, ranging from employment history, to prior experiences with debt, to extenuating circumstances (like having a credit score dropped 100 points because of nothing the person did), to why they need the credit. It won’t be as easy and it will take up more of their time. But in the end, I think it will get us back to a system where decisions are made in a more humane way and in a way that lowers risk for all concerned. So here’s to the death of FICO. May the credit industry continue to dig its early grave.